INTEREST RATES: Myth and reality of Reserve Bank independence

by Colin Teese

News Weekly, November 6, 2004

There are almost as many reasons put forward as to why Labor lost the Federal election as there are people to ask. But one of the more widely held views is that Labor could not counter the view put forward by the Prime Minister that the Coalition was the better economic manager.

Perhaps so. But what cannot be denied is that the Opposition Leader and his team were strangely silent on the subject. Some wise heads have suggested that Labor could not criticise the Government on some of its weaker areas of economics management (like debt) because its own economic policies are identical with the Government's.

In the end, however, it does seem that, putting all else aside, the Government was able to persuade voters that, under Labor, interest rates would rise: and that was less likely under the Coalition. Of course, the Coalition's proposition is riddled with holes (some of these will be examined later). It was, nevertheless, enough to scare the pants off those red-blooded householders standing behind a mountain of mortgage debt.

Short-term tactic

In the short term the tactic worked; but now the question is whether the reality which stands behind it will not come back to haunt the Prime Minister and his Treasurer quite early in the life of their new government.

There are a number of reasons why this could happen. Some are purely political in character, while others contain a disturbing mix of economic policy considerations, which could make our economy very difficult to manage. But to understand all of this, it is necessary to go back a step or two.

In the run-up to the election - indeed, for most of this year - readers of this journal will recall being told that, given the heat in the housing market alone, there was a justification for lifting interest rates.

And housing wasn't the only reason. In the event, interest rates were not raised - and we all know why not. Yet interest rate movement is the only policy instrument the Reserve Bank can use to fight inflation.

Thus, for some of us, the question then arises as to whether or not the Bank is genuinely independent of political influence in the carrying out of its obligation to contain inflation.

Despite all of this, the standard pundits - and including those who most strenuously advocate the virtues of a fully independent Reserve Bank - kept telling us that, with an election in the wind, there would be no interest rate increase until the election was behind us.

So we were entitled to ask - though few of us did - how come, if the Reserve Bank is fully independent, does the fact of an impending election enter into its decision-making equation?

It will be recalled that the Reserve Bank, back in the Hawke and Keating days, was - somewhat ostentatiously - made independent of government. Or so it was said.

The reason for this change was made abundantly clear. Monetary policy - that is the movement in the level of official interest rates - was the instrument for controlling inflation, and only the Reserve Bank (in reality the Governor of the Reserve Bank) could be trusted to exercise this power independently of short-term party-political considerations.

So far, nobody has chosen to challenge the view that the Bank was operating independently of political interference.

In part, this has been because influential financial writers have constantly allowed their readers to assume that the setting of official interest rates was the sole preserve of the Bank's Governor - a public official operating on a fixed-term contract.

Of course, this has never been so - now, or at any other time in the Bank's history. The Governor is merely chairman of a board of the bank, which collectively decides on the movement of interest rates. And, guess who appoints the board? The Government!

So, unless you believe that the Government's own appointees - especially with an election imminent - will endorse an action which could work to the disadvantage of the Government which appointed them, then surely, you can't believe in the idea of Reserve Bank independence.

The reality is, whatever steps might be undertaken to keep it at arm's length, the Bank can never hope to remain immune from political influence, either direct or indirect.

The question therefore to be addressed is whether political control is to be direct, and therefore visible, as it once was, or exercised from behind the scenes as is now the case.

In a democracy, there are compelling reasons why direct and visible political influence might be preferable - even inescapable.

First, and obviously, the Government should not be able to escape responsibility for whatever are the consequences - economic or otherwise - arising from interest rate adjustments.

And second, can the Reserve Bank - given the direction of inflationary pressures which now impact upon our economy - actually control inflation with no other policy instrument at its disposal than the management of interest rates?

And even if that were achievable, is it any longer possible for the Reserve Bank to do its work without taking into account non-economic factors.

Political interference

In other words, if non-economic considerations must enter into the Bank's deliberations, it should not, and cannot, possibly avoid political interference.

In the economic circumstances currently unfolding for the new government, these issues may assume greater than academic interest almost immediately.

Inflation is already high and is increasing rapidly, as has been pointed out in the Melbourne Age in the last week or so.

The figures are really quite alarming. Producer-input inflation is soaring. Producers are compelled to pay more for energy, metals, construction materials, utilities and food - whether these inputs are sourced domestically or imported.

Obviously, these price increases are being, and will continue to be, passed on to consumers.

As already indicated, much of this increase in producer prices is attached to imports. And this is a natural consequence of our decision to wind down our manufacturing sector.

As has been said many times, our manufacturing sector is now near the bottom of the OECD table of countries. The deficit on manufacturing is now $A77 billion (up from $A46 billion in 1996).

And the inflation contained in that deficit - over which we, or our Reserve Bank, have absolutely no control - is now feeding itself into our economy - at the consumer level directly, and indirectly, through cost increases for producer inputs into locally produced goods.

Inflation now seems to be running at around five per cent - well above the level the Reserve Bank is supposed to defend.

Consider what all of this means for the new government.

Mr Howard won the election on the basis of a commitment to low interest rates. Now raw economic policy considerations, largely beyond his control, are telling him interest rates must rise.

Will those mortgage-belt voters, who took seriously the Prime Minister's claim to superior economic management, understand and accept eagerly, the need to pay more for their mortgages?

Or will their support for Mr Howard evaporate?

And here, precisely, is the moment when the question of the independence, or otherwise, of the Reserve Bank assumes critical importance.

Control of inflation, in the two to three per cent range, we are told, is absolutely essential to sustainable prosperity. And Reserve Bank independence is the only way to get that outcome.

Yet the Bank is boxed in. Interest rate movement is the only instrument at its disposal for managing inflation. Bank policy is committed to contain inflation at around two to three per cent.

It is now well beyond that level for both producer and consumer inflation, has been for some time, and the Bank has not acted.

Overridden

Technical economic considerations have been overridden by the political realities of election timing. But what about now?

The way lies open for the Bank to take the heat out of the economy by lifting interest rates. Always this will be at the expense of consumer spending - including on house repayments.

But are consumers ready to make the necessary sacrifices? Will they be prepared to accept an interest rate rise large enough to bite deeply enough into consumer spending to make a difference?

And what if curtailing consumer spending cuts off the avenue to future growth expectations? Will the cure turn out to be worse than the disease?

We don't know, but what we can say is that the consequences are likely to be more political than economic.

For example, could the Government afford to see interest rates rise to levels which might alienate its mortgage-belt supporters?

We shall have to see. And, in the process, we may find out who really controls Reserve Bank policy; and, incidentally, how important present inflation rate parameters really are to sustained economic growth.